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ETF Specialist

Has the ETF Arbitrage Mechanism Failed?

Why fixed-income ETFs traded far from NAV, and how the situation has improved.

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The past several months in the markets have brought forth so many events that were unprecedented in most investors' experience that we have become inured. Dividends are being cut left and right for the first time since the early 1970s, some fixed-income mutual funds have lost more than 80% of their value, and the once-proud owner of the world's largest market capitalization has debt trading at levels we saw only in junk bonds a scant couple years ago. Along with these changes, we have seen one more event that we were told would never happen: ETFs trading at a persistent discount or premium to their net asset value.

The Arbitrage Mechanism
The mechanism that keeps ETFs trading close to their NAV is a process called in-kind redemption and creation. Essentially, the fund must publish, every 15 seconds, an up-to-date version of its portfolio, including the vast majority of securities it holds and the amount of cash necessary to buy the rest. The fund also publishes an estimated cash value of those holdings, known as an Intraday Indicative Value, based upon the most recent prices of the securities in its basket. At any point in the trading day, major banks and trading desks known as authorized participants can come to the fund with a basket of the underlying securities given in the published holdings, which the fund will exchange for a creation unit consisting of a set number of shares in the ETF (typically 50,000).

Similarly, the APs could also buy up shares in the ETF on the market, then exchange them with the fund in return for the published basket of underlying holdings. So if the market price for the ETF starts to rise too far above the price of its underlying stocks or bonds, the APs will buy the underlying holdings, exchange them for shares in the ETF, and sell enough of those shares to drive the price back down to net asset value. Similarly, APs will buy up any shares of the ETF trading at a discount so that they can turn in large blocks of shares for the more expensive underlying securities. This drives prices for the ETFs close to the prices for the underlying stocks and bonds and produces some of the incredible tax benefits of ETFs to boot.

When Panic Strikes
However, this arbitrage works only if APs can trade the funds' underlying stocks and bonds. When panic strikes, trading can dry up quickly in less-liquid areas of the market, causing market prices for index funds to deviate substantially from the calculated value of their underlying holdings.

The first time we noticed these deviations on a major scale was in October 2008. After a relatively placid August and (by today's standard) minor falls in the stock market through September, early October saw the fallout from the Lehman Brothers explosion begin to settle on the financial landscape. In eight trading days, the S&P 500 fell 23% from 1,166 to 899. The intrabank lending markets saw even worse devastation, as institutions suddenly refused to trade with one another for fear of counterparty collapse. With this sudden spike in uncertainty over the future of corporate America, corporate-bond markets froze by Oct. 10. No one knew what would happen to default rates or interest rates in the future (remember how we went from an inflation scare to the threat of deflation in about two months?) and prices had already fallen substantially, so market participants simply refused to buy any more.

Bond markets are particularly prone to this problem due to the sheer number of securities out there. Each public company has only a share class or two of common stock and perhaps a small handful of preferred shares traded on exchanges, but it could have dozens or even hundreds of different bonds issued at a variety of coupon rates and maturities. Because there's no exchange publishing prices, the corporate-bond market also depends heavily on major broker-dealers who keep a large inventory of bonds on their books for any potential buyer. After the collapse of Lehman Brothers, those broker-dealers were trying to reduce the size and risk of their assets at the same time institutions and investors were trying to sell out of corporate bonds, so the market had no major buyers and no ways for the few willing smaller investors to publicize their buy prices on the myriad corporate bonds available.

However, there were now bond ETFs trading on the stock exchanges. Investors and institutions eager to sell their risky corporate bonds had to settle for hedging their exposure by instead selling the still-liquid basket of bonds on the market. This drove down the market price for the ETFs while the net asset value stood still due to the lack of new prices on the underlying securities. The APs who would normally jump at discounts of 5%-10% refused to take on more corporate-bond exposure by purchasing the millions of dollars of shares necessary to redeem for the underlying portfolio, and they couldn't find any buyers for the underlying bonds anyway. Any brave investors who bought the major aggregate-bond ETFs issued by iShares, Vanguard, or SPDRs may have bought at a large discount on paper, but they were likely paying a fair price for the basket of bonds due to the sheer uncertainty about future values and the liquidity they were providing. During the few days when panic sweeps over a market like it did in October 2008, net asset values mean very little due to the lack of fresh prices, and frequently traded ETFs provide a better estimate of their holdings' true value than any estimate based on the old prices.

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Bradley Kay does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.